Solving SME Development Challenges:
Looking Beyond Easy Loan Schemes

Solving SME Development Challenges:
Looking Beyond Easy Loan Schemes

Like many countries in the region, SME development remains prominently on the policy agenda of successive Sri Lankan governments, development projects, and private sector support programmes over the years. Yet, a thriving, dynamic, and internationally-competitive SME sector remains elusive. Various schemes to address SMEs’ access to finance issues is a popular, and often dominant, part of most SME development initiatives. In this interview with finance and investment specialist Sharini Kulasinghe we explore some new perspectives on solving SME development challenges, going beyond the common wisdom. Sharini is a freelance consultant in impact investment. She was previously the Co-Head of Investment Banking at Asia Securities, a leading investment firm in Sri Lanka. Prior to that she was part of the investment team at the US-based impact-focused asset manager.

SFF: Sharini, SME development has been on the policy agenda for decades now, ever since the SME White Paper in 2002, and there have been plenty of initiatives to improve SME competitiveness in general and access to finance for SMEs, in particular. Yet, we haven’t seen much meaningful change. In your opinion, where are we going wrong?

SK: Well, I feel the key issue has been that there hasn’t been a concentrated effort to really understand and define the specific problems SMEs face. First, the idea of SME itself is a very broad category, and there is a lot of diversity within it. The Central Bank of Sri Lanka defines SMEs as companies with less than LKR750 million in revenue – this can include agricultural businesses, restaurants, footwear manufacturers, IT companies, etc; it will also include companies that were established 5 years ago and those that are now being managed by a third generation of owners; and it includes businesses that generate LKR50 million in revenue and those that generate LKR700 million in revenue. Each of these businesses face different problems and need different solutions, which cannot be addressed through a one size fits all model, which is how most discussions around SMEs are framed.

Secondly, there are few, if any systematic efforts to understand the specific problems SMEs face from the ground up – ie: by talking to SMEs. Often, it is assumed that access to finance is the biggest issue they face. However, while many SMEs I have spoken with certainly consider access to finance as a key issue, they also struggle with things like access to export markets, barriers to clearing imported items, labour supply shortages, lack of management capacity and sometimes even inability to access affordable technology solutions. If these issues are not addressed, improving access to finance will not necessarily help improve SMEs. For example, access to finance won’t help an SME that is struggling to find export markets for its products.

So in summary, I think that a successful SME policy needs to begin with a clear assessment of the constraints SMEs face, rather than an assumption around access to finance.

SFF: Lets focus specifically on access to finance for a bit. There’s plenty written about it, and many programmes to try to solve it. Before we get into solutions, I want to first ask – how do you characterize the access to finance problem that SMEs face in Sri Lanka, from your own assessments and observations?

SK: Globally, SME financing is challenging and the situation is no different in Sri Lanka. Banks give loans to companies if they believe that it is likely to be repaid. Generally, this analysis has two main considerations – 1) the extent of security that the company provides and 2) whether the company can generate sufficient cash flows to repay the loan. SMEs often lack the kind of collateral (usually fixed assets like property, vehicles, etc) that banks need as security. In addition, many SMEs do not have stable, consistent cash flows, which makes evaluating their repayment capacity challenging. This is compounded by the fact that many SMEs do not maintain clear records, so banks are unable to evaluate their past performance accurately.

SFF: Moving now to solutions. Time and again various initiatives have tried to tackle it, mainly through concessional credit schemes as it seems to be the ‘go to’ policy tool that successive governments, and indeed donor programmes, have used. Yet, the problem still persists. Why do you think this is?

SK: Concessional credit schemes are an attractive tool because they can be implemented quickly. If well designed, they can also help build strong, sustainable SMEs. However, if poorly designed they may just end up subsidizing weak SMEs that do not have a strong business model, and are likely to fail in the long run, rather than supporting SMEs with strong growth prospects.

The concessional credit schemes I’ve seen fall into two broad buckets – those that subsidize the cost of finance for SMEs and those that subsidize the cost of risk for the lending institution. The former involves a donor or government providing lost cost financing to a bank and requiring them to pass on these cost savings to their borrowers. This enables SMEs to borrow at lower than market rates. If an SME requires low cost funding to operate, the business is unlikely to be sustainable and grow in the long-term. Sources of concessional funding are irregular and always dry up at some point. When this happens, SMEs that are dependant on it will struggle and possibly fail. In effect, these credit schemes just prolong the lifetime of these SMEs. They do not target and support SMEs with strong growth prospects. Unfortunately, most of the concessional schemes that have been rolled out recently fall into this bucket.

Concessional credit schemes that subsidize the cost of risk to the lending institution can be quite interesting. These schemes involve reimbursing lending institutions for part of the losses they suffer on loans to SMEs (usually, specific categories of SMEs in priority sectors). This motivates banks to lend to SMEs in priority sectors that they may otherwise have found too risky. This opens up a whole new category of SMEs to the formal banking sector, and over time, can help build strong SMEs. These schemes involve a lot more work and are harder to design, so haven’t been as prevalent.

SFF: So, how can we improve how the banking and non-bank finance sector facilitates SME financing more effectively? What are some of the tools and products that you believe have been under-explored or under-utilized in Sri Lanka?

SK: One thing I would love to see more of in Sri Lanka is lenders using data to better evaluate the credit risk of SMEs. I noted before that banks often find it hard to lend to SMEs because of their irregular cash flows and the lack of good records. Said another way, one of the issues banks have is the lack of good information on the financial health of SMEs. There are a number of initiatives SME lenders are pursuing to overcome these issues, and many of them are based on finding and using data as a part of the credit decision. I’ve seen credit scoring models based on a variety of data sources – from electricity payments, to evaluation of previous bank statements, to information on weather patterns. Others deploy various AI on various data like current cash flow, growth potential and market data. In more digitized societies, I’ve even seen models that scrub companies social media pages! There is a lot that can be done with data and technology to overcome the information issues that lenders face in evaluating SME credit.

SFF: There have been, and still are, attempts to introduce more equity financing options than debt. In fact, you were also part of an ADB study that looked into this. What were some of your main findings on equity as a better or an additional option for SME growth in Sri Lanka?

SK: It was a really interesting study. We surveyed around 100 SMEs to understand their capital requirements. This makes the study one of the larger systematic surveys on SMEs capital requirements, but I do think that there is plenty of room for this work to be updated and expanded. We came up with a few conclusions on the equity requirements of SMEs. First, we realized there are really two types of SMEs who need equity – 1) start-ups that were established in the least 5 years and have high growth expectations; and 2) more established SMEs that have low or moderate growth expectations. The equity financing requirements of start-ups is well documented, so I won’t go into that here, other than to say that this is a high risk, high reward proposition that has been well served by venture capitalists in Sri Lanka and around the world.

The equity financing requirements of the established SMEs, is less documented, but is in fact much larger. Around 40% of established SMEs required external financing. Some of them did not have scalable operations and therefore would not be appropriate for equity investment. However, many of them did have business models with strong growth potential and required external capital to make investments to grow. Of these SMEs, some wanted to make long-term investments that were not well served by the relatively short-term nature of bank loans. Others wanted to make medium term investments, but did not have the collateral that banks require. The growth of these SMEs was inhibited by lack of access to equity capital.

However, we realized that traditional equity capital is rarely well suited to most established SMEs. First, these SMEs rarely deliver the kind of equity returns of 15%+ that most equity investors require given the risk they are taking. Secondly, a lot of established SMEs also told us that they were reluctant to bring on external investors for fear of diluting control. As such, we felt quasi-equity instruments would be more appropriate to address the requirements of SMEs. These are instruments that have both debt and equity features. For example, royalty-based financing where investment repayments are determined as a percentage of revenue. These type of instruments give cash flow relief to SMEs making long term investments. However, they also provide upside to investors if the investments are successful. There are many examples of this being done successfully around the world. Business/Partners, an SME financier that operates across Sub Saharan Africa is one of my favourite examples. They tailor their financing solution for each SME, and use a combination of debt, equity and equity-like instruments to do that. They began in South Africa in the 1980s as a public-private partnership to support SMEs and have grown to now serve SMEs across the continent.

SFF: If you had to share just one piece of advice for the Sri Lankan banking sector on how they can improve their SME lending, what would it be? And if you had to share just one piece of advice for a donor, development project or government programme that was trying to roll out a new ‘SME assistance scheme’, what would it be?

SK: I actually think that the SME departments in many banks and finance companies do quite a good job at understanding their clients requirements. They are unfortunately limited by lending policies around collateral requirements as well as the lack of adequate information to assess the credit quality of an SME. While there is no clear solution to the lack of collateral, I do think that there are emerging solutions around credit scoring that may help them get around the lack of information. This of course requires significant investment and resolve. For donors, I believe the ideal first step is to define the people you want to help and listen to what they need. I know that doing this in a systematic way can be costly and time-consuming. However, it’s important because access to finance may not necessarily be the primary issue they face. Even if it is, it is unlikely one that can be easily solved with providing low cost finance. All solutions should begin once the needs of the target SMEs are clearly defined.

SFF: In closing, it’s useful to wrap up where we started – about going beyond access to finance. What would a robust “SME development programme” look like to you, given all of the nuances that you mentioned we should be mindful of, which you mentioned earlier – ranging from firm size to tackling root causes?

SK: That’s a hard question to answer, because ideally, it should start by systematically asking SMEs what they need! That said, there are a couple of things that I would keep in mind in designing such a program. The first would be to choose a few target sectors. A broad program that tries to support all SMEs around the country will be near impossible to design and even harder to implement. Target sectors could be defined based on national priorities – for example, focusing on a few export oriented sectors in either manufacturing or services would make sense given current national priorities. Once the priority sectors are identified, I think a successful program would take a comprehensive view of the challenges SMEs face relating to growth and operations. On the growth side, I have found that many SMEs I have spoken to just don’t have access to global and local value chains. There has been a lot of research around this issue and initiatives have been launched all over the world that try to tackle it. These range from local ideas like market linkage programs, training and development and technology transfer to the more strategic ideas like attracting MNEs and systematically building a strong ecosystem for the success of local SMEs in that sector (ie: the semiconductor industry in Malaysia). On the operations side, SMEs face a complex set of challenges, which include inadequate access to technology, lack of access to quality human capital, disruptive regulation, etc. Again, there is a lot of research and prior experience in tackling these issues. One thing that these issues have in common is that they are a lot more complex to address that access to finance. They usually involve quite a bit of creativity in designing the design phase and often require a number of different stakeholders to implement. In addition, they can take some time to bear fruit. However, I believe they are well worth the effort, because resolving the issues around access to finance alone cannot build vibrant SMEs that face a complex set of systematic challenges.

Cover image: A small enterprise in the Achchuveli Industrial Estate in Jaffna, northern Sri Lanka. (c) Anushka Wijesinha.